Adam Kefford (PKF Francis Clark) and Curt Welker (PKF California) explain the tax issues affecting a UK business making online sales to retail customers located in California.
Question
I am a UK business making online sales to retail customers located in the US state of California. I do not have a permanent establishment in the US under the terms of the UK/US tax treaty. However, I have recently become aware of the economic nexus concept and possible state level tax issues. What is meant by ‘economic nexus’ and which US and UK tax issues do I need to consider?
Answer
Understanding the potential exposure to US state income taxes when trading with US customers is vital. The UK business should factor into its pricing model any US tax costs which may not be fully recoverable against its UK tax liability, i.e. it represents a cost of sale. The failure to register and comply with its obligations can lead to backdated liabilities, penalties and interest on unpaid tax.
The issue has been particularly apparent in recent due diligence assignments. In three separate cases, the target companies had economic nexus in the states of California, Michigan and New York. In each case, the directors were unaware of their US obligations, leaving the lawyers to consider how best to cover the buyer’s risk.
Understanding the US tax system
According to the US Census Bureau’s annual survey of state government tax collections, the US states collected $916bn of state level tax in 2015, of which income tax accounted for $387bn. Each US state is eager to maximise its tax take and boost its public coffers in a time where several states are in financial difficulties and facing budget deficits.
The US tax system operates at two main levels: the federal level; and an individual state level. Therefore, when selling into the US, it is necessary to consider the rules and regulations both of the federal tax code and of each state’s tax code. As a result of each state’s ability to act relatively independently with regards to tax, each state has been able to develop its own tax rules in order to maximise tax revenue, even though this may not be entirely consistent with the federal tax system.
Often, UK companies will understand their federal position and be comfortable that, under the terms of the UK/US tax treaty, they do not have a taxable presence in the US for federal tax purposes. However, in our experience, very little thought is given to the state tax position, which can leave the UK company potentially exposed to significant state level taxation.
US permanent establishment
Article 7 of the UK/US tax treaty sets out that the business profits of a UK resident company can only be subject to US federal tax if the company has a permanent establishment in the US. The term ‘permanent establishment’ (PE) is defined in article 5. Detailed commentary on the treaty is beyond the scope of this article. Broadly speaking, however, a US PE is created if the UK company carries on business in the US either through a fixed place of business (e.g. a branch, office or factory) or through a dependent agent which habitually concludes contracts in the name of the UK company.
A detailed review of the facts will be required to assess whether the UK company does have a US PE. I recommend that if you act for a UK company making sales to the US, the possible creation of a PE is considered. Addressing this issue as soon as possible is desirable, in order to avoid any future issues around the non-filing of federal tax returns.
Factor based economic nexus
After reviewing the PE position, the conclusion has been reached that there is no PE and therefore no exposure to US federal taxes. It is easy at this stage to think that the US tax position has been addressed and put to bed.
A state may assess a UK company to income tax if it can establish the business as having nexus in the state. ‘Nexus’ is another word for ‘connection’. Traditionally, it was thought that nexus could not be created without a physical presence; this is a view that is now changing in certain quarters.
A state’s economic nexus test can differ substantially from the PE test defined by the UK/US tax treaty. Crucially, as the tax treaty is a federal instrument, most states consider that it has no relevance for state tax purposes. Factor based economic nexus can be triggered by breaching the thresholds set for sales, local payroll costs or property. For example, it is entirely feasible that a UK company does not have a PE under the tax treaty but does have a filing obligation and liability for state income tax, because sales in the state exceed a certain level.
Public Law No. 86-272
Public Law (PL) No. 86-272 may offer some protection from the state nexus rules. PL 86-272 says that a state cannot impose a net income tax if the taxpayer’s only contact with the state is the solicitation of orders for the sale of tangible personal property, when orders are sent outside of the state for acceptance and are filled by shipment or delivery from outside the relevant state.
Some states, such as Michigan, interpret this law as providing protection from state income tax, including to foreign non-US resident companies. Therefore, a UK company making sales to Michigan via the internet only would not be exposed to Michigan tax, even if it breached the state’s nexus threshold.
This view is supported by the Supreme Court case of Quill Corp. v North Dakota (1992) 504 US 298, which underlined the idea that an enterprise can only be subject to state taxes in a state in which it has a physical presence.
However, there are some states, such as California, which do not take this view; instead, they take the approach that the safe harbour provided by PL 86-272 only applies to inter-state business. Such states have been encouraged by the case of Geoffrey Inc. v South Carolina Tax Commission (1993) 437 SE2d 13, which indicated that economic nexus was possible; and also by the introduction of a factor based economic presence test by the Multistate Tax Commission (MTC) in 2002, with nine states subsequently adopting these recommendations.
As one might imagine, there is considerable confusion as to whether the use of a factor based economic nexus test by the states is actually legal, and this remains an ongoing point of debate. What is not in doubt is that a number of states (approximately ten at the end of 2015) are using economic nexus tests with clear purpose and that this trend is likely to increase. This means the issue is real and should be taken seriously.
Californian tax position
For tax years beginning on or after 1 January 2011, California adopted new economic nexus standards (California Revenue and Taxation Code section 23101(b)). In general, the Franchise Tax Board will consider a foreign corporation to have a Californian corporate income and franchise tax nexus if the business has:
sales in California exceeding the lesser of $547,711 or 25% of the total sales of the business;
real and tangible property in California exceeding the lesser of $54,771 or 25% of the total real and tangible property of the business; or
payroll in California exceeding the lesser of $54,771 or 25% of the total wage bill paid by the business.
(The above limits apply for taxable years beginning on or after 1 January 2016.)
This means a UK ecommerce business would only need to sell approximately £430,000 of goods to Californian customers in a US tax year before it triggered local state income tax obligations.
Once nexus is established in California, which requires a tax return to be filed, the net income of the unitary business is apportioned to California to determine the amount of income subject to California tax. The apportionment is determined by using a numerator consisting of sales delivered to customers in California over a denominator which consists of total worldwide sales of the unitary business.
Although discussion of what constitutes a unitary business is beyond the scope of this article, in general California interprets a unitary business as a group of corporations that has more than 50% common ownership and that engages in unitary operations, including intercompany functional integration, centralised management and economies of scale. If a unitary operation is determined to exist, California asserts the right to tax the combined income of all worldwide net income using the California apportionment factor. Therefore, even if the operations are not profitable in California, there would be California tax due if the worldwide operations were profitable.
(Note that if the UK entity has an onshore US corporate subsidiary or affiliate, California will allow a so-called water’s edge election to be made to exclude any non-US entities from the combined unitary income. However, if the foreign group is selling directly into California and does not have a US corporate entity presence, the water’s edge election cannot be made.)
As an example, assume that a UK parent and its subsidiaries have a combined worldwide turnover of £20m and net profits of £4m. Assume further that the UK entity is selling £5m into California (an amount well in excess of that required to establish economic nexus), solely through e commerce. Because the entity is trying to penetrate a competitive market, it is only break even on its California branch operations.
If the worldwide operations are determined to be unitary, as discussed above, the UK will be subject to California tax, as follows:
Double tax relief
A UK company is able to claim double tax credit relief for the lower of the UK corporation tax payable and the foreign tax paid in respect of the foreign source income. As there is no US PE, then there is no US federal income tax to consider.
Article 2 of the UK/US treaty sets out the taxes covered by the treaty. State taxes are not included, so a claim for credit relief would need to be on a unilateral basis. Under TIOPA 2010 s 9, unilateral relief is available for foreign taxes which are charged on income and which correspond to UK income tax or corporation tax. HMRC helpfully sets out in its Double Taxation Manual at DT19855 to DT19855C a list of admissible and inadmissible state taxes, which should be referred to when assessing the availability of unilateral relief.
When calculating the amount available for relief, it will be necessary to determine the UK corporation tax liability on the net profit of the US sale. It is possible that differences in calculating the tax base will result in the Californian income tax liability exceeding the UK tax liability, resulting in irrecoverable foreign tax.
As one can imagine, the process of filing back returns with the IRS, while simultaneously seeking refunds from HMRC generated by DTR claims, is not ideal and should be avoided where possible by identifying this issue upfront.
Income tax is not the only tax
Of course, income tax is not the only tax levied by the states – a number of taxes are levied by the states. Potentially the most important is state sales and use tax, which is broadly analogous to UK VAT.
While the issues in play are slightly different here, it is possible that states will seek to adopt factor based economic nexus tests with a view to triggering local sales tax liabilities for foreign corporations doing business with US customers. Such a move would have the result that margins would be eroded.
In 2016, the Colorado case of Direct Marketing Ass. v Brohl (2015) 575 US upheld the idea formed in Quill Corp. v North Dakota that for sales tax purposes a physical presence is required for an out of state business to become liable. However, this was not a Federal Supreme Court case, and that is what is really required to put the legality of the factor based economic nexus tests to bed once and for all. The client should therefore be aware that this is a situation that could change.
Action points
It is clear that UK businesses making sales to US customers need to consider state taxes more closely, particularly where significant sums which are likely to breach the factor based thresholds are in play.
UK advisers should:
discuss the concept of economic nexus with those clients that have US sales;
discuss with the client the nature of its activities in the US;
assess whether there are any ‘risk’ states where economic nexus may have been created (the tax authority for the majority of states has its own website, which is a useful first port of call);
obtain tax advice from a local US tax adviser specialising in ‘state and local taxes’ in the relevant state to understand whether nexus has been created and the implications thereof; and
continue to monitor the development of factor based economic nexus tests for the purposes of state income and sales taxes in particular.
Adam Kefford (PKF Francis Clark) and Curt Welker (PKF California) explain the tax issues affecting a UK business making online sales to retail customers located in California.
Question
I am a UK business making online sales to retail customers located in the US state of California. I do not have a permanent establishment in the US under the terms of the UK/US tax treaty. However, I have recently become aware of the economic nexus concept and possible state level tax issues. What is meant by ‘economic nexus’ and which US and UK tax issues do I need to consider?
Answer
Understanding the potential exposure to US state income taxes when trading with US customers is vital. The UK business should factor into its pricing model any US tax costs which may not be fully recoverable against its UK tax liability, i.e. it represents a cost of sale. The failure to register and comply with its obligations can lead to backdated liabilities, penalties and interest on unpaid tax.
The issue has been particularly apparent in recent due diligence assignments. In three separate cases, the target companies had economic nexus in the states of California, Michigan and New York. In each case, the directors were unaware of their US obligations, leaving the lawyers to consider how best to cover the buyer’s risk.
Understanding the US tax system
According to the US Census Bureau’s annual survey of state government tax collections, the US states collected $916bn of state level tax in 2015, of which income tax accounted for $387bn. Each US state is eager to maximise its tax take and boost its public coffers in a time where several states are in financial difficulties and facing budget deficits.
The US tax system operates at two main levels: the federal level; and an individual state level. Therefore, when selling into the US, it is necessary to consider the rules and regulations both of the federal tax code and of each state’s tax code. As a result of each state’s ability to act relatively independently with regards to tax, each state has been able to develop its own tax rules in order to maximise tax revenue, even though this may not be entirely consistent with the federal tax system.
Often, UK companies will understand their federal position and be comfortable that, under the terms of the UK/US tax treaty, they do not have a taxable presence in the US for federal tax purposes. However, in our experience, very little thought is given to the state tax position, which can leave the UK company potentially exposed to significant state level taxation.
US permanent establishment
Article 7 of the UK/US tax treaty sets out that the business profits of a UK resident company can only be subject to US federal tax if the company has a permanent establishment in the US. The term ‘permanent establishment’ (PE) is defined in article 5. Detailed commentary on the treaty is beyond the scope of this article. Broadly speaking, however, a US PE is created if the UK company carries on business in the US either through a fixed place of business (e.g. a branch, office or factory) or through a dependent agent which habitually concludes contracts in the name of the UK company.
A detailed review of the facts will be required to assess whether the UK company does have a US PE. I recommend that if you act for a UK company making sales to the US, the possible creation of a PE is considered. Addressing this issue as soon as possible is desirable, in order to avoid any future issues around the non-filing of federal tax returns.
Factor based economic nexus
After reviewing the PE position, the conclusion has been reached that there is no PE and therefore no exposure to US federal taxes. It is easy at this stage to think that the US tax position has been addressed and put to bed.
A state may assess a UK company to income tax if it can establish the business as having nexus in the state. ‘Nexus’ is another word for ‘connection’. Traditionally, it was thought that nexus could not be created without a physical presence; this is a view that is now changing in certain quarters.
A state’s economic nexus test can differ substantially from the PE test defined by the UK/US tax treaty. Crucially, as the tax treaty is a federal instrument, most states consider that it has no relevance for state tax purposes. Factor based economic nexus can be triggered by breaching the thresholds set for sales, local payroll costs or property. For example, it is entirely feasible that a UK company does not have a PE under the tax treaty but does have a filing obligation and liability for state income tax, because sales in the state exceed a certain level.
Public Law No. 86-272
Public Law (PL) No. 86-272 may offer some protection from the state nexus rules. PL 86-272 says that a state cannot impose a net income tax if the taxpayer’s only contact with the state is the solicitation of orders for the sale of tangible personal property, when orders are sent outside of the state for acceptance and are filled by shipment or delivery from outside the relevant state.
Some states, such as Michigan, interpret this law as providing protection from state income tax, including to foreign non-US resident companies. Therefore, a UK company making sales to Michigan via the internet only would not be exposed to Michigan tax, even if it breached the state’s nexus threshold.
This view is supported by the Supreme Court case of Quill Corp. v North Dakota (1992) 504 US 298, which underlined the idea that an enterprise can only be subject to state taxes in a state in which it has a physical presence.
However, there are some states, such as California, which do not take this view; instead, they take the approach that the safe harbour provided by PL 86-272 only applies to inter-state business. Such states have been encouraged by the case of Geoffrey Inc. v South Carolina Tax Commission (1993) 437 SE2d 13, which indicated that economic nexus was possible; and also by the introduction of a factor based economic presence test by the Multistate Tax Commission (MTC) in 2002, with nine states subsequently adopting these recommendations.
As one might imagine, there is considerable confusion as to whether the use of a factor based economic nexus test by the states is actually legal, and this remains an ongoing point of debate. What is not in doubt is that a number of states (approximately ten at the end of 2015) are using economic nexus tests with clear purpose and that this trend is likely to increase. This means the issue is real and should be taken seriously.
Californian tax position
For tax years beginning on or after 1 January 2011, California adopted new economic nexus standards (California Revenue and Taxation Code section 23101(b)). In general, the Franchise Tax Board will consider a foreign corporation to have a Californian corporate income and franchise tax nexus if the business has:
sales in California exceeding the lesser of $547,711 or 25% of the total sales of the business;
real and tangible property in California exceeding the lesser of $54,771 or 25% of the total real and tangible property of the business; or
payroll in California exceeding the lesser of $54,771 or 25% of the total wage bill paid by the business.
(The above limits apply for taxable years beginning on or after 1 January 2016.)
This means a UK ecommerce business would only need to sell approximately £430,000 of goods to Californian customers in a US tax year before it triggered local state income tax obligations.
Once nexus is established in California, which requires a tax return to be filed, the net income of the unitary business is apportioned to California to determine the amount of income subject to California tax. The apportionment is determined by using a numerator consisting of sales delivered to customers in California over a denominator which consists of total worldwide sales of the unitary business.
Although discussion of what constitutes a unitary business is beyond the scope of this article, in general California interprets a unitary business as a group of corporations that has more than 50% common ownership and that engages in unitary operations, including intercompany functional integration, centralised management and economies of scale. If a unitary operation is determined to exist, California asserts the right to tax the combined income of all worldwide net income using the California apportionment factor. Therefore, even if the operations are not profitable in California, there would be California tax due if the worldwide operations were profitable.
(Note that if the UK entity has an onshore US corporate subsidiary or affiliate, California will allow a so-called water’s edge election to be made to exclude any non-US entities from the combined unitary income. However, if the foreign group is selling directly into California and does not have a US corporate entity presence, the water’s edge election cannot be made.)
As an example, assume that a UK parent and its subsidiaries have a combined worldwide turnover of £20m and net profits of £4m. Assume further that the UK entity is selling £5m into California (an amount well in excess of that required to establish economic nexus), solely through e commerce. Because the entity is trying to penetrate a competitive market, it is only break even on its California branch operations.
If the worldwide operations are determined to be unitary, as discussed above, the UK will be subject to California tax, as follows:
Double tax relief
A UK company is able to claim double tax credit relief for the lower of the UK corporation tax payable and the foreign tax paid in respect of the foreign source income. As there is no US PE, then there is no US federal income tax to consider.
Article 2 of the UK/US treaty sets out the taxes covered by the treaty. State taxes are not included, so a claim for credit relief would need to be on a unilateral basis. Under TIOPA 2010 s 9, unilateral relief is available for foreign taxes which are charged on income and which correspond to UK income tax or corporation tax. HMRC helpfully sets out in its Double Taxation Manual at DT19855 to DT19855C a list of admissible and inadmissible state taxes, which should be referred to when assessing the availability of unilateral relief.
When calculating the amount available for relief, it will be necessary to determine the UK corporation tax liability on the net profit of the US sale. It is possible that differences in calculating the tax base will result in the Californian income tax liability exceeding the UK tax liability, resulting in irrecoverable foreign tax.
As one can imagine, the process of filing back returns with the IRS, while simultaneously seeking refunds from HMRC generated by DTR claims, is not ideal and should be avoided where possible by identifying this issue upfront.
Income tax is not the only tax
Of course, income tax is not the only tax levied by the states – a number of taxes are levied by the states. Potentially the most important is state sales and use tax, which is broadly analogous to UK VAT.
While the issues in play are slightly different here, it is possible that states will seek to adopt factor based economic nexus tests with a view to triggering local sales tax liabilities for foreign corporations doing business with US customers. Such a move would have the result that margins would be eroded.
In 2016, the Colorado case of Direct Marketing Ass. v Brohl (2015) 575 US upheld the idea formed in Quill Corp. v North Dakota that for sales tax purposes a physical presence is required for an out of state business to become liable. However, this was not a Federal Supreme Court case, and that is what is really required to put the legality of the factor based economic nexus tests to bed once and for all. The client should therefore be aware that this is a situation that could change.
Action points
It is clear that UK businesses making sales to US customers need to consider state taxes more closely, particularly where significant sums which are likely to breach the factor based thresholds are in play.
UK advisers should:
discuss the concept of economic nexus with those clients that have US sales;
discuss with the client the nature of its activities in the US;
assess whether there are any ‘risk’ states where economic nexus may have been created (the tax authority for the majority of states has its own website, which is a useful first port of call);
obtain tax advice from a local US tax adviser specialising in ‘state and local taxes’ in the relevant state to understand whether nexus has been created and the implications thereof; and
continue to monitor the development of factor based economic nexus tests for the purposes of state income and sales taxes in particular.
